Fever pitch – There is mounting evidence of aggressive, risk-taking behaviour in markets

16/10/2013

Jamie Lowry

Fund Manager, Equity Value

Here on The Value Perspective, as articles such as Cloudy forecast prove, we yield to no-one in our distrust of experts’ ability to predict the future. What we do believe is possible though is – as Howard Marks puts it in his book, The most important thing: uncommon sense for the thoughtful investor– to take the temperature of the market as the pendulum, as it were, arcs between fear and greed.

We can, in other words, look for signs of despair or signs of froth so let’s do that by considering a number of risks building up across the market that people are as yet failing to acknowledge. We have done this recently with pik toggle bonds in Take your pik and Pik-ing holes but we can point to other areas of the market where we are seeing a worrying amount of aggressive, risk-taking behaviour.

Take the evidence of the following graph, which shows that issuance of something called the ‘covenant-lite loan’ has reached an all-time high. These loans, as the name just about suggests, impose less stringent terms on borrowers. For example, they may choose not to impose a limit on the total amount of debt a company can take on – which of course means they are much riskier for lenders.

As you might expect, a loan with fewer covenants enables a lender to ask for a higher rate of interest but demand for covenant-lite loans is actually being driven by the borrowers. At certain points in the cycle, a company will ask a number of investment banks to pitch for the chance to lend it money and the banks will have to judge an appropriate balance between interest charged and covenants imposed.

What happens is the banks start degrading the terms and conditions in the loans in order to seal the deal. As with pik toggle bonds, the pick-up in return from covenant-lite loans is rarely enough to compensate for the additional level of risk, which is why an apparent increase in the issuance of both instruments generally points to an inflating credit bubble.

Our next example is from a recent Financial Times (FT) article on how collateralised loan obligation (CLO) issuance has – you’ve guessed it – hit its highest level since before the financial crisis. Not to mince words, the packaging of large numbers of loans – mortgages, auto loans, credit card loans and so forth – that were then sliced up and sold off in tranches by banks were a major cause of the credit crisis. Not only did their structure make it impossible to analyse the underlying risks but the process itself caused underwriting standards to deteriorate.

As such, their resurgence to post-bubble highs hardly instils confidence. still, just so we can avoid accusations of being too focused on credit markets, let’s end with an equity example, courtesy again of an FT article, which notes the lowest level of ‘shorts’ on European markets since records began in earnest in 2006. At the same time, shorts on US markets are also touching record lows.

By definition, people short the market when they think asset prices are set to fall, so obviously record low levels of shorts indicate soaring confidence in equities. The return of PIK toggle bonds, high levels of covenant-lite loans and CLO issuance and record lows on shorting in Europe – as we take the market’s temperature, all these point towards everything growing a bit overheated. Investors should take note.

Author

Jamie Lowry

Fund Manager, Equity Value

I joined Schroders in 2004 as an equity analyst in the European Equity Team initially specializing in the Industrial sectors before moving on to Consumer-based companies and finally Insurance. In 2007, I became a co-manager on a fund investing in undervalued European companies and took on sole responsibility for the fund in May 2010. Prior to joining Schroders, I worked at Hedley & Co Stockbrokers and Deutsche Asset Management as a trainee analyst.

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